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Canada Outlook: Loosening the Reins

Canada's rate of growth will accelerate in 2014, further reducing labor market slack.

The loonie's depreciation will help rebalance trade and push inflation toward the central bank's target faster than expected.

The cheaper currency will boost Canadian competitiveness, and could spur business investment.

The Canadian economy grew at a lackluster rate in 2013, but is poised for faster growth in 2014 as the U.S. recovery accelerates. Fiscal headwinds and policy uncertainty in the U.S. and Europe have weighed heavily on both investor sentiment and the trade balance since 2012, slowing growth in the Canadian economy to an estimated 1.8% last year. But momentum is clearly building.

Production disruptions made growth uneven, but it reached an annualized 2.7% in the third quarter, from 1.6% in the second; recent data suggest the economy held at roughly that pace through the fourth quarter, bringing year-ago growth above the economy’s 2% potential rate for the first time since the second quarter of 2012.

Demand in the U.S., Canada’s principal export market, grew even faster, approaching 4% through the second half of 2013. Moody’s Analytics forecasts U.S. real GDP will grow by a more moderate but still-strong 3.2% in 2014 and by 3.8% in 2015. This will lift Canada's exports and capital investment, putting the expansion on a more sustainable footing.

Household consumption and housing demand have been key to the economy since the recovery began, but this has caused the ratio of household debt to disposable income to reach troublingly high levels. Household borrowing has moderated substantially over the past year, lessening but not eliminating fear of a credit bubble.

Soft landing, with risks

Rising household saving rates, if accompanied by stronger income generation from exports and business investment, should support a soft landing for Canadian retailing and housing. But downside risks are significant: Many households, particularly recent homebuyers, may find their finances stretched as interest rates are pulled upward by the U.S. Federal Reserve's withdrawal of monetary stimulus.

Should household saving increase because of slower consumption demand, rather than faster income growth, Canada's economy will lose its last pillar, and financial markets may exacerbate the shock via lower asset prices and higher borrowing costs.

After holding at 6.9% for three months, the unemployment rate jumped 0.3 point to end the year at 7.2% with a surprisingly weak December jobs report. This should be reversed quickly in the first quarter, however, with the jobless rate averaging less than 7% and falling thereafter. Moody’s Analytics expects Canada's unemployment rate to average 6.7% this year and 6.4% in 2015.

Two arguments underpin this projection. First, December’s rise in the unemployment rate can be best explained as an adjustment back toward equilibrium rather than a change in fundamentals. Specifically, employment and participation data show less slack in the labor market than warranted, given the slack in the overall economy last year. Based on the Bank of Canada’s measure of the output gap and the economy’s prerecession equilibrium rate of unemployment, the unemployment rate in 2013 should have averaged 7.4%, rather than the 7.1% reported.

Much of the difference is attributable to a rise in self-employment last year. Part-time work has also been increasing. To some degree, this has caused the headline unemployment rate to overstate strength in the labor market. Job displacements from the recession also appear to have lowered participation rates, with some older workers permanently sidelined. Participation rates remain closer to trend among younger workers, but unemployment rates remain elevated.

Despite the employment bias of Canada’s heavily resource-driven growth toward younger male workers, much of the slack in the labor market remains concentrated among youth and men under age 55. To a large extent, this reflects the geographical segmentation of Canada’s job market, with an excess supply of young workers in the eastern provinces and excess demand in parts of the western portion of the country.

Fundamentals that were weak in 2013 are growing stronger, however; this is the second and more important reason for a positive outlook. Healthier private sector balance sheets and receding fiscal headwinds from austerity in the U.S. and Europe support stronger demand for Canadian goods and services.

Despite the U.S. shale boom, accelerating U.S. growth will sustain demand for Canadian energy exports through the medium run. Transportation bottlenecks will constrain immediate growth in production and sales and continue to weigh down North American oil prices, but pent-up demand for capital investment in Canada’s resource industries will support job growth and improve productivity into the next decade.

Boosting competitiveness

The Canadian dollar tumbled quickly in the fourth quarter, falling toward US$0.90 in January after averaging rough parity with the greenback for several years. New concerns about emerging-market growth, combined with a brighter U.S. outlook and the winding down of the Fed’s quantitative easing, accelerated the depreciation starting in December. The result has been a decline in the real exchange rate to a level consistent with more balanced trade.

The loonie has historically sold at a discount against the greenback, making nominal prices for most goods and services higher in Canada than their equivalents south of the border. However, rising global demand for Canadian commodities and a flight to safety since the recession led to a marked appreciation in the currency. This priced Canadian exports out of many global markets and shifted the trade balance from surplus to deficit, and has dragged on capital formation and retail sales.

Retail tourism

High productivity and a cheap currency once gave Canadian manufacturing a competitive advantage, but both slipped away after the turn of the millennium. This led multinational firms to lean toward divestment, rather than reinvestment, in Canadian operations despite the country’s relatively strong performance among G-7 nations. Cheaper U.S. goods and services also encouraged retail tourism by Canadians in recent years, with cross-border shopping trips boosting many northern U.S. states at the expense of their neighbors north of the border.

Without a nominal depreciation in the currency, competitiveness pressure forced an internal devaluation via two years of disinflation. The Bank of Canada’s measure of core inflation fell steadily during 2012 to the lower threshold of the bank’s mandated target range of 1% to 3%, and has remained near that 1% lower bound for much of the past year. With inflation low in the U.S. and Europe as well, slower growth in Canadian wages and prices produced little improvement in overall cost competitiveness. In the central bank’s view, it has also raised the importance of downside inflation risks.

Central banks are typically more risk-averse when inflation appears too low than they are when it is too high. This is because there is no constraint on how high the bank can lift interest rates to combat high inflation. On the downside, the zero bound limits their ability to keep disinflation from spiraling into actual deflation. As a result, monetary policymakers at the Bank of Canada have adopted a more dovish tone even while acknowledging that a stronger U.S. outlook may be reducing the probabilities of these risks.

Rapid currency depreciation may alter the bank’s stance once again, however, as it increases upside risks to inflation through two channels. The first is stronger demand for exports, with associated demand for new jobs and new capital investment. As the job market tightens, wage pressures will build. The second is through import prices: About one-third of Canadian national income is spent on imported goods and services, which are nearly 10% more expensive than a year earlier.

Fundamental concerns

Continued slow growth in productivity remains a fundamental challenge to sustaining Canada’s competitiveness and income growth over the long run. Since 2000, the gap in productivity between U.S. and Canadian workers has widened, exacerbated by the far more severe pressures placed on the U.S. labor market during the Great Recession, which have led to much slower wage growth in the U.S. since 2007. The combination of slower productivity growth and steadier wage gains has caused unit labor costs in Canada to grow at a much faster pace than those of other major trading partners.

The cheaper loonie will do much to improve Canada’s competitive position in the short run, but longer-run export prospects hinge on real efficiency gains, not simply discounted prices. Canada continues to lag the U.S. in innovation and entrepreneurship, but the recipe for fostering more rapid productivity growth remains as much a puzzle in Canada as elsewhere.

Size matters

One recent explanation for Canada’s lagging productivity lies in differences in the composition of firm size. In both Canada and the U.S., labor productivity is typically higher in larger firms than smaller ones. However, the share of output produced by small firms is higher in Canada than in the U.S.; at the same time, the productivity gap between small and large firms appears larger in Canada. By one estimate, these two factors explain more than half of Canada's productivity gap with the U.S.

These long-run concerns will remain a drag on Canadian equity prices. Despite benefiting from the same drop in long-run yields generated by Fed bond-buying, the Canadian stock market significantly underperformed the U.S. market last year, a reflection of greater concerns over long-run profitability. Risks remain particularly elevated surrounding the energy sector, with the fate of future pipeline development and competition from U.S. producers still both far from certain. Key technology and manufacturing have also struggled this year. However, stronger global growth, a more appropriately priced currency, and continued inflows of foreign capital and workers will help sustain the profitability of Canadian industry over the longer run.